Developing a New CMBS Hedging Tool: A Property Price Index-Based Synthetic by Juthatham Bo Chirathivat Bachelor of Architecture, 2003 Cornell University Submitted to the Department of Architecture In Partial Fulfillment of the Requirements for the Degree of Master of Science in Real Estate Development at the Massachusetts Institute of Technology September 2007 ©2007 Juthatham Bo Chirathivat All rights reserved The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part in any medium now known or hereafter created. Signature of Author _____________________________________________ Department of Urban Studies and Planning July 27, 2007 Certified by ____________________________________________________ David Geltner Professor of Real Estate Finance Department of Urban Studies and Planning Thesis Supervisor Accepted by ____________________________________________________ David Geltner Chairman, Interdepartmental Degree Program in Real Estate Development 2 Developing a New CMBS Hedging Tool: A Property Price Index-Based Synthetic by Juthatham Bo Chirathivat Submitted to the Department of Architecture On July 27, 2007 in Partial Fulfillment of the Requirements for the Degree of Master of Science in Real Estate Development Abstract By isolating credit as a distinct asset class, credit derivatives provide new vehicles for synthetically trading and transferring credit exposure of commercial real estate without buying or selling the physical assets. Recent developments of CMBS index-based synthetics, namely the CMBX, have allowed systematic market exposure to a basket of CMBS credit default swaps. The creation of these credit derivatives indices has enabled market participants to trade rating-specific risk, hedge against market-wide credit risk, and express a macro view within the CMBS sector. This thesis identifies the key underlying source of credit default risk as the commercial real estate market itself, and explores the concept of a CMBS default risk synthetic that is based on transaction-based commercial property price index movements. Such indices would allow investors to more precisely target and hedge the particular risk in their CMBS portfolios that is exposed to specific commercial real estate markets tracked by the indices. The thesis proposes a methodology for the new synthetic product to approximately replicate the credit loss behavior of specific rated tranches of a CMBS. This thesis utilizes Monte Carlo simulation to test the hedging performance of the proposed property price index-based synthetic, considering both cash flow correlation and hedge ratio analyses. The results reveal that the effectiveness of the hedge varies depending on the investor’s horizon or degree of temporal precision the investor seeks in the hedge, as well as the target tranche rating. The hedge ratio is very dynamic throughout the life of the synthetic, suggesting that the investor buying the synthetic for hedging purposes would need to rebalance his position accordingly. The author believe that the possibility of utilizing commercial property price indices to structure equity index-based credit derivatives, as demonstrated by methodologies in this thesis, will enhance investment and risk management strategies for CMBS investors, facilitating access to the breadth and depth of existing real estate equity indices. Further pioneering efforts in the development of credit derivatives will be a catalyst for a tremendous growth in the CMBS market. Thesis Supervisor: David M. Geltner Title: Professor of Real Estate Finance 3 4 Acknowledgements I would like to give my sincerest appreciation to Professor David Geltner for his inspiration, insightful guidance, and enthusiastic support for my thesis. Thank you for making this thesis possible, and more importantly, a fun and wonderful learning experience. I wish to acknowledge Neal Elkins for his innovative ideas and real world advice on this thesis. I owe very special thanks to my parents and my brother for their unconditional love, and for giving me moral, intellectual, and emotional support throughout my twenty-seven years. I am forever grateful for their encouragement and unwavering faith in me. I also would like to thank all my friends and professors who have made the past year at MIT an amazing journey of discovery. 5 6 Table of Contents Acknowledgements ....................................................................................................... 5 Introduction................................................................................................................... 9 Chapter One: Commercial Mortgage Credit Risk .......................................................11 Embedded Options in a Commercial Mortgage......................................................................... 11 Option Pricing Approach to Mortgage Valuation...................................................................... 15 Chapter Two: The Evolution of CMBS Credit Derivatives......................................... 23 Single-Name CMBS Credit Default Swap Synthetic .................................................................. 24 CMBS Index-Based Synthetic: The CMBX................................................................................. 29 Applications of CMBS Credit Derivatives................................................................................... 31 Chapter Three: The Property Index-Based CMBS Synthetic..................................... 35 Important Considerations for Index-Based Derivatives ........................................................... 37 The Stylized CMBS Pool: Simplifying Assumptions for the Analysis..................................... 43 The CMBS Synthetic Product........................................................................................................ 45 The Synthetic Price Process ........................................................................................................... 47 The Synthetic Payoff Structure...................................................................................................... 50 The Hypothetical CMBS Portfolio ............................................................................................... 55 The Credit Loss Structure of the Hypothetical CMBS Portfolio............................................. 57 Chapter Four: Testing the Hedging Performance of the Synthetic Product.............. 59 Quarter-by-Quarter Correlations................................................................................................... 61 Quarter-by-Quarter Hedge Ratio .................................................................................................. 64 Centered-Rolling 5-Quarter Average Correlations..................................................................... 67 Centered Rolling 5-Quarter Average Hedge Ratios ................................................................... 69 Conclusion................................................................................................................... 72 References.................................................................................................................... 75 7 8 Introduction Commercial Mortgage-Backed Securities (CMBS) provide an important source of funding for commercial real estate in the U.S. According to the Commercial Mortgage Securities Association, CMBS issuance in the U.S. alone reached a record of $207 billion in 2006. The recent surge of liquidity in real estate capital markets led to unusually high commercial property price appreciation, which in turn suppressed CMBS delinquency rates, and also led to complacency in loan underwriting. Investors in the CMBS market are of course subject to credit risk, and the recent risky loan underwriting1 combined with credit problems in some sectors of the home mortgage industry have raised alarms about the possible need for more and better tools for hedging and trading commercial CMBS credit risk exposure. Together with recent developments in the bond market credit risk derivatives industry, this suggests that the time may be opportune for the development of innovative credit risk derivative products aimed at the U.S. CMBS and commercial mortgage industry. Indeed, recent developments in CMBS credit derivatives are already beginning to provide new vehicles for trading and transferring credit risk of commercial real estate synthetically without buying or selling the physical assets. The credit derivative is often referred to as the synthetic CMBS. The development and growth of real estate credit derivatives will further enhance CMBS’ reputation as a mainstream asset class in the fixed income market, and allow investors to broaden and enhance credit risk management capabilities. Much of the recent development in CMBS credit derivatives has focused on tools to hedge against systematic market exposure. Existing synthetic trades in the CMBS market are designed as a default swap directly based on a CMBS index, such as the CMBX. This thesis explores the concept of a CMBS default risk synthetic, based on commercial property price index movements. Such indices track the key underlying source of credit risk, the commercial real estate market itself, and might allow investors to more precisely target risk exposures in their particular CMBS portfolios, or to more efficiently trade the risk they want to buy or sell. This thesis proposes and examines a new product idea to